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Need to Know: Morgan Stanley sees an earnings wipe out ahead for Wall Street’s unloved stock rally

A previous version of this report incorrectly described a planned oil production cut. The article has been corrected.

Hunting for optimists the Monday after an explosive jobs and debt-ceiling fueled relief rally that sent the S&P 500 SPX, +0.18% to the edge of a bull market, is proving a little tough. That said, there’s nothing horrible in the setup, with tech just a little softer as oil is up after Saudi Arabia pledged another production cut.

“This is an unloved rally for sure – SPX above 4,200 and out of the [4,000-4,200] range just as the VIX VIX, +3.77% drops to its lowest since Feb 2020,” notes Neil Wilson, chief market analyst at Finalto.

What Friday did show us is that Big Tech’s rally can spread itself around when it wants to, so more days like that and some Wall Street sourpusses may change their tune. For now, though it seems those who didn’t sell in May are being told to prune in June.

Read: A Fed skip? A pause? Even so, investors aren’t likely out of the woods.

That brings us to our call of the day, and let the tomatoes fly, as our favorite bear is back — Morgan Stanley’s “Worried” Mike Wilson, who still expects “a meaningful earnings recession this year (-16% year-over-year decline) that has yet to be priced in,” by stock markets.

While his S&P 500 base case remains unchanged at 3,900, the lower end of Street forecasts, the strategist says investors are stuck in the middle of several ‘hotter but shorter’ earnings cycles in the context of a broader secular bull market — boom, bust, boom, the strategist said in a Sunday note.

Wilson says the bank’s expectations for a bigger stock drop have been kept at bay by the outperformance of AI players and some big tech names, Fed pivot fever and hopes we’ve been through the worst of an earnings recession. But, a major repricing has hit lower quality, cyclical and small-cap stocks, he adds.

The strategist offers some guidance on when the market will finally start pricing in that earnings rout, focusing on the equity risk premium (ERP) portion of the price/earnings (PE) ratio.

The ERP is defined as the difference between the expected earnings yield and the yield on safe Treasurys, with a higher number meaning investors are being compensated more for putting money in stocks.

He said more than 100% of the reset on PE last year was due to higher 10-year Treasury yields. “Historically, that ‘moment of recognition’ for the market typically occurs when the forward NTM [next 12 months] EPS forecast for the S&P 500 goes negative on a y/y [year over year] basis.” The expected liquidity drain from the debt ceiling passage may help push this process along, he said.

Source: Morgan Stanley

So if an investor is buying what Wilson is selling they will take his advice to stick to defensive characteristics, operational efficiency and earnings stability.

But to avoid leaving things on a totally crummy note, Wilson does add a light at the end of the tunnel. Morgan Stanley expect a 23% bounce in EPS growth in 2024 and 10% in 2025, as Fed policy turns more accommodative in 2024 (not 2023). Here are more drivers of the next recovery/bull market post correction:

  • More stable starting point for consumer balance sheets in aggregate
  • AI and its diffusion across sectors
  • Productivity pickup
  • Capex cycle, industrial automation
  • Positive operating leverage and margin expansion re-emerge
  • Cleantech and reshoring of related critical infrastructure
  • Housing supply shortage

The markets

Stocks DJIA, -0.19% SPX, +0.18% COMP, +0.31% opened flat after Friday’s powerful post-jobs rally that also sent the Dow industrials DJIA, -0.19% surging 700 points. The 10-year Treasury note is up 4 basis points to 3.730%. The dollar DXY, -0.02% is higher and gold GC00, +0.20% and silver SI00, -0.70% are lower.

Oil prices CL.1, +1.21% BRN00, +1.33% are higher in the wake of OPEC’s decision to cut oil supply by 1 million barrels a day.

For more market updates plus actionable trade ideas for stocks, options and crypto, subscribe to MarketDiem by Investor’s Business Daily. Follow all the stock market action with MarketWatch’s Live Blog.

The buzz

Data showed U.S. factory orders rose for the fourth gain in the past five months, while the Institute for Supply Management services gauge grew at a slower pace in May, with demand leveling off. And it’s a blackout period for the Fed as its June 13-14 Fed meeting looms.

Circor stock CIR, +50.13% has surged toward a five-year high, following a deal to be acquired by KKR valued at $1.6 billion, including debt.

Analyst says Apple AAPL, +1.77% has three multi-billion-dollar opportunities in its pipeline. Apple executives will take the stage Monday at the WWDC developer conference, and are expected to unveil a long-awaited mixed-reality headset.

U.S. regulators are planning fresh rules that will force bigger banks to lift their capital requirements by an average 20%, The Wall Street Journal reported.

UBS said its acquisition of rival Credit Suisse Group should be completed as early as June 12, at which point the latter’s shares will be delisted and those shareholders will get one UBS share for every 22.48 outstanding ones held.

A private gauge of China’s service activities rose up in May, expanding for the fifth straight month.

Palo Alto Networks PANW, +3.92% stock is up 5% on S&P 500 inclusion, replacing Dish Networks DISH, +0.21%, whose shares fell 6%.

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The chart

Here’s another look at how lopsided the stock market is currently, with this chart included in The Weekly S&P500 #ChartStorm, from @lhamtil:

The tickers

These were the top tickers on MarketWatch, as of 6 a.m.:

Ticker Security name
TSLA, +2.63% Tesla
NVDA, -0.94% Nvidia
GME, +3.29% GameStop
AAPL, +1.77% Apple
AMC, +1.98% AMC Entertainment
AI, +3.64% C3.ai
PLTR, +5.89% Palantir Technologies
NIO, +4.20% NIO
BUD, -0.03% Anheuser-Busch InBev
MULN, -6.11% Mullen Automotive

Random reads

The world is running low on pink paint. Thanks a lot, Barbie.

$2 million for three brand-new, 13-year old Teslas.

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